Great Wealth: Step by Step

February 1, 2011 — Leave a comment

When you hear about a very wealthy person, you might try to learn what steps were taken to achieve the wealth, so you can repeat them to become wealthy. In most cases, you will fail, because you have different circumstances or because luck played a big role. This article presents a systematic way for maximizing your wealth, regardless of your circumstances.

The article does not mention ideas that depend on luck, tough predictions or that may be difficult to follow, including:

  1. Work for the next Google, start it, or invest in it.
  2. Buy real estate in a location that will boom in the next 10 years.
  3. Become a famous actor, artist, musician, or writer.

It also avoids ideas that are useful, but depend on your individual abilities, and some luck, including:

  1. Become the CEO of a large company.
  2. Become a highly paid professional.

As you may pursue some of the approaches above, this article focuses on things that you can control better. Given the limited space, it is not a comprehensive guide for maximum wealth, but it should steer you in the right direction.

Step 1: Live below your means. The first ingredient for systematic wealth generation is to save as much as possible from your income. It is easiest to be frugal if you are happy, because unhappy people are at risk of using spending to make up for the missing happiness. More importantly, if you are not happy, what is the point of becoming wealthy? Here are a few ideas for maximizing your happiness with minimal spending:

  1. Find a job/business/activity where you are appreciated. Start by finding your strengths and passions. If you can find work that you are both passionate about and is in demand, you are set. Otherwise you may have to find a compromise, or split your time between two occupations: one that makes you happy and a less ideal one to pay the bills.
  2. Surround yourself with people that you can connect with, whether family, friends, or people with a common interest. Prefer people that build up your energy.
  3. Help others. While official volunteer work is a clear example, you can find ways to help people around you at all times, whether it is a family member, friend, co-worker, client or a complete stranger.
  4. Fill up your time with cheap fun activities, for example:
    • Walk, hike or ride a bike
    • Watch the ocean
    • Read books from the library
    • Play games, do puzzles, socialize
    • Listen to music
    • Garden
  5. Don’t overwork for extended periods. While the extra work can increase your savings, you might get burned out, or simply overspend to compensate for the work stress.

Do whatever it takes to live within your means and save some amount regularly. Knowing that life is financially sustainable is critical for staying peaceful and relaxed. Since we tend to focus on changes in life and not the absolute position, knowing that you are growing your savings is relaxing.

For many people, this may be the toughest step, and may require creative actions, including:

  1. Obtaining new skills through a degree or some form of training.
  2. Making changes to the circle of friends or even moving to a different place, where there is less pressure to live at a certain material standard.
  3. Selling assets and belongings that are expensive to maintain, including houses, cars or boats.

Once you established expenses that are below your income, be very strong at keeping the expenses from growing much. For any increase in your income, use most of it for increased savings.

Step 2: Build cash reserves. Save several months of living expenses in a low risk place, such as cash in a checking or savings account. This may not be easy, because this money does not grow much. A big motivation is the thought about how helpful this money would be if there is an unexpected emergency expense or you lose your job.

Step 3: Save into a globally diversified stock portfolio, with no market timing and no individual stock selection. If done right, this step can be really fun. You have to educate yourself about the extreme volatility of stock investments, as well as the high long-term rewards and the reasons for them. Whether you invest on your own or with the help of a professional investment advisor, it is critical for the person managing the money to have iron discipline.

Step 4: Use money to make money. Once you started building an investment portfolio, there are several ways in which you can use your money to reduce your expenses or increase your savings growth:

  1. Count a small withdrawal rate from your portfolio as a part of your reserves for emergencies. While stocks are very volatile in the short run, they can tolerate a low withdrawal rate at all times. This depends on the portfolio, and can be in the range of 2%-4%.
  2. Increase the deductibles on various insurance policies, such as car, home and health. When doing so, make sure you are prepared financially and mentally to spend the money out of your own savings, and don’t do so if you are at a much higher risk than the average insured.
  3. Increase the mortgage on your home, as long as you can sustain the payments through low withdrawals from your investments, and you have iron discipline!
  4. Switch from a fixed mortgage to a variable rate, unless your fixed rate is very low. Fixed mortgages cost more to compensate the lender for interest rate risk.

The last two points require very careful analysis – I do not recommend doing them without the help of an experienced professional.

Step 5: Keep a watch on expenses. As you grow your savings and/or income, it can become increasingly difficult to keep the material standard of living from growing. A few ways of dealing with it are:

  1. Raise your standard of living with the growth of your income, but do so minimally and choose things that maximize the growth of your happiness.
  2. Instead of thinking about your low (and declining) standard of living relative to your income and/or assets, think about your growing standard of living.
  3. Remember that more money (beyond a pretty basic amount) typically does not make people happier. That is where a focus on happiness first can help.

Step 6: Financial freedom . Once your investments grow to the point where your annual living expenses amount to no more than 2%-4% of your investments (depending on the portfolio), you will achieve financial freedom! Now you can choose to spend your time in any way that will make you happy. As a huge added bonus, you can keep growing your spending whenever your investments grow to new peaks, without reducing your financial security.

Example : If you can save 10% of your income per year and put it into a stock portfolio with real long-term growth of 12% per year (nominal growth 15% minus 3% inflation), you can reach financial freedom (at a 4% withdrawal rate) within 31 years. Note: I assume that the growing income allows for an increased saving rate. This is a reasonable assumption because wages have historically grown about 1% faster than inflation in the long run.

For income of $100,000, and $10,000 saved per year, you may reach $2.5M in 31 years.

If you stop working at that point, and withdraw 4% of your portfolio per year, you may see your assets and available income double every 9 years, reaching $10M, 24 years into your full retirement.

Notes about the steps above:

  1. They are pretty simple. You don’t have to be very talented, lucky or smart to follow them. You do have to be strong and consistent. This requirement is what fails most people.
  2. They are not guaranteed to make you wealthy or happy. They are general guidelines. Stock growth can vary from its average for extended periods, and the average may change over time.
  3. They are not appropriate for everyone. Some people place greater emphasis on the present, and are willing to accept higher financial risk and lower future wealth. There is no right or wrong – it is a clear tradeoff.
Disclosures Including Backtested Performance Data

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Gil Hanoch

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